Chapter 30

Money Growth and Inflation

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 Inflation, Part 1
• Inflation
– Increase in the overall level of prices
• Deflation
– Decrease in the overall level of prices
• Hyperinflation
– Extraordinarily high rate of inflation

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 Inflation, Part 2
• 2008 to 2018
– Prices rose at an average rate of 1.5% per
year
• The 1970s
– Prices rose by 7.8% per year
– The price level more than doubled over
the decade

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posted to a publicly accessible website, in whole or in part.
 Inflation, Part 3
• International data, 2018 inflation rate
– 2.4% in the U.S
– 1.2 percent in Japan
– 4.8 percent in Mexico
– 12 percent in Nigeria
– 15 percent in Turkey
– 32 percent in Argentina
• February 2008, Zimbabwe
– 24,000% (hyperinflation)
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 The Classical Theory of Inflation, Part 1
• Classical theory of money
– Quantity theory of money
– Explain the long-run
determinants of the price level
– Explain the inflation rate

“So what’s it going to

be? The same size as
last year or the same
price as last year?”

N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or 5
posted to a publicly accessible website, in whole or in part.
 Level of Prices; Value of Money
• Inflation
– Economy-wide phenomenon
– Concerns the value of economy’s medium
of exchange
• Inflation: rise in the price level
– Lower value of money
– Each dollar buys a smaller quantity of
goods and services

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posted to a publicly accessible website, in whole or in part.
 The Classical Theory of Inflation, Part 2
• Money demand
– Reflects how much wealth people want to
hold in liquid form
– Depends on
• Credit cards
• Availability of ATM machines
• Interest rate
• Average level of prices in economy
– Demand curve – downward sloping

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posted to a publicly accessible website, in whole or in part.
 The Classical Theory of Inflation, Part 3
• Money supply
– Determined by the Fed and the banking
system
– Supply curve is vertical
• In the long run
– Money supply and money demand are
brought into equilibrium by the overall
level of prices

N. Gregory Mankiw, Principles of Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or 8
posted to a publicly accessible website, in whole or in part.
Figure 1 How the Supply and Demand for Money
Determine the Equilibrium Price Level

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posted to a publicly accessible website, in whole or in part. 9
 Effects of a Monetary Injection, Part 1
• Economy is in equilibrium
– If the Fed doubles the supply of money
• Prints bills
• Drops them on market
– Or the Fed: open-market purchase
– New equilibrium
• Supply curve shifts right
• Value of money decreases
• Price level increases

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posted to a publicly accessible website, in whole or in part.
Figure 2 An Increase in the Money Supply

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 Effects of a Monetary Injection, Part 2
• Quantity theory of money
– The quantity of money available in the
economy determines (the value of money)
the price level
– Growth rate in quantity of money available
determines the inflation rate

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posted to a publicly accessible website, in whole or in part.
 Effects of a Monetary Injection, Part 3
• Adjustment process
– Excess supply of money
– Increase in demand of goods and services
– Price of goods and services increases
– Increase in price level
– Increase in quantity of money demanded
– New equilibrium

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posted to a publicly accessible website, in whole or in part.
 Classical Dichotomy, Part 1
• Nominal variables
– Variables measured in monetary units
• Dollar prices
• Real variables
– Variables measured in physical units
• Relative prices, real wages, real interest rate
• Classical dichotomy
– Theoretical separation of nominal and real
variables
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posted to a publicly accessible website, in whole or in part.
 Classical Dichotomy, Part 2
• Developments in the monetary system
– Influence nominal variables
– Irrelevant for explaining real variables
• Monetary neutrality
– Changes in money supply don’t affect real
variables
– Not completely realistic in short-run
– Correct in the long run

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posted to a publicly accessible website, in whole or in part.
 Velocity and the Quantity Equation, Part 1

• Velocity of money (V)

– Rate at which money changes hands
• V = (P × Y) / M
P = price level (GDP deflator)
Y = real GDP
M = quantity of money

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posted to a publicly accessible website, in whole or in part.
 Velocity and the Quantity Equation, Part 2

• Quantity equation: M × V = P × Y
• Quantity of money (M)
• Velocity of money (V)
• Dollar value of the economy’s output of goods
and services (P × Y )
– Shows: an increase in quantity of money
• Must be reflected in:
– Price level must rise
– Quantity of output must rise
– Velocity of money must fall

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posted to a publicly accessible website, in whole or in part.
Figure 3 Nominal GDP, the Quantity of Money, and
the Velocity of Money

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posted to a publicly accessible website, in whole or in part. 18
 Quantity Theory of Money, Part 1
1. Velocity of money
– Relatively stable over time
2. Changes in quantity of money, M
– Proportionate changes in nominal value of
output (P × Y)
3. Economy’s output of goods & services, Y
– Primarily determined by factor supplies
– And available production technology
– Money does not affect output
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 Quantity Theory of Money, Part 2
4. Change in money supply, M
– Induces proportional changes in the
nominal value of output (P × Y)
• Reflected in changes in the price level (P)
5. When the central bank increases the
money supply rapidly
– High rate of inflation

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 The Inflation Tax
• The inflation tax
– Revenue the government raises by
creating (printing) money
– Like a tax on everyone who holds money
• When the government prints money
• The price level rises
• And the dollars in your wallet are less
valuable

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 The Costs of Inflation
• Shoeleather costs
– Resources wasted when inflation
encourages people to reduce their money
holdings
– Can be substantial
• Menu costs
– Costs of changing prices
– Inflation – increases menu costs that firms
must bear
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posted to a publicly accessible website, in whole or in part.
 Relative-Price Variability
• Market economies
– Relative prices allocate scarce resources
– Consumers compare quality and prices of
various goods and services
• Determine allocation of scarce factors of
production
– Inflation distorts relative prices
• Consumer decisions are distorted
• Markets are less able to allocate resources to
their best use
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posted to a publicly accessible website, in whole or in part.
 Inflation-Induced Tax Distortions

• Taxes distort incentives

– Many taxes: more problematic in the
presence of inflation
• Tax treatment of capital gains
– Capital gains are profits
• Sell an asset for more than its purchase price
– Inflation discourages saving
• Exaggerates the size of capital gains
• Increases the tax burden

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posted to a publicly accessible website, in whole or in part.
 Confusion and Inconvenience
• Money
– Yardstick with which we measure
economic transactions
• The Fed’s job
– Ensure the reliability of money
• When the Fed increases money supply
– Creates inflation
– Erodes the real value of the unit of
account
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posted to a publicly accessible website, in whole or in part.
 Arbitrary Redistributions of Wealth
• Unexpected inflation
– Redistributes wealth among the
population
• Not by merit
• Not by need
– Redistribute wealth among debtors and
creditors
• Inflation: volatile and uncertain
– When the average rate of inflation is high
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posted to a publicly accessible website, in whole or in part.